First rate increase since 2006 right thing to do

How does the Fed rate hike affect student loans?

For the first time in nine years, the Federal Reserve has raised interest rates. Borrowing costs will steadily rise for consumers and businesses. But how will your student loan repayments be impacted during this historic change? That depends on wh

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For the first time in nine years, the Federal Reserve has raised interest rates. Borrowing costs will steadily rise for consumers and businesses. But how will your student loan repayments be impacted during this historic change? That depends on wh

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WASHINGTON

The Federal Reserve’s decision this week to raise interest rates – for the first time in nearly a decade – was fraught with controversy.

But it was, on balance, the right thing to do. In addition to the tightening labor market and the other data-driven reasons that Fed officials cited Wednesday for taking action, there would have been two very real, if more abstract, risks to not raising rates: a potential loss of confidence in the economy and a potential loss of confidence in the Fed itself.

Let’s be clear: The Fed had faced a tough decision, given the muddiness of recent economic data. There was no obvious right answer.

The central bank has a dual mandate – stable prices and maximum employment – and there is generally believed to be a trade-off between the two. Unfortunately, these days it’s not really clear which half of the mandate deserves more TLC, given the weird state of the world.

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At just 5 percent, the unemployment rate looks spectacularly low, while inflation has been under the target rate of 2 percent for about three years. So in theory, the Fed is doing OK on both objectives. But there are reasons to question the accuracy, or at least usefulness, of both of those headline numbers, given how few people are in the labor force and that ultra-low energy prices are distorting inflation indices.

As a result, experts cannot agree on whether the economy is fundamentally healthy. An ambiguous diagnosis means that the appropriate treatment (to hike or not to hike) is ambiguous, too.

That said, the prescription that the Fed offered Wednesday – raising the Fed’s key interest rate by a measly quarter of a point – is such a minor intervention that it was largely symbolic. There’s just not that big of a difference between interest rate targets of zero to 0.25 percent and 0.25 to 0.5 percent. Either way, monetary policy remains highly “accommodative,” and interest rates are still very, very low.

In fact, even after Wednesday’s much-ballyhooed hike, today’s effective interest rate remains lower than it was at any point during the more than five decades leading up to the recent financial crisis.

Given all that, now imagine how markets might have freaked out if the Fed had chosen not to take this tiny step toward normalization. Especially because the Fed has for so long indicated that a rate hike would be appropriate once the job market looked more or less as it does today.

Yet another delay might have signaled that the Fed had suddenly gotten much more worried about the underlying health of the economy, and that investors should be more worried, too.

“There is a growing sense in academia that markets learn from Fed announcements not only about future monetary policy but also about the future outlook,” notes Jon Steinsson, a Columbia University economics professor.

At least one anonymous Fed policymaker even made this point in September, according to Federal Open Market Committee minutes, saying “a prompt decision to firm policy could provide a signal of confidence in the strength of the U.S. economy that might spur rather than restrain economic activity.”

Likewise, when the October minutes were released and indicated that a December rate hike was likely, stock markets rose – even though, at least in theory, tightening the money supply should depress stock prices.

Markets went up again when the hike was finally announced this week. That may have happened because, while the hike was itself expected, the unanimous support it received from the committee was not. Having not a single dissent, even from members who had previously expressed reservations about raising rates this year, sent a strong, and probably contagious, message of confidence in the economy.

If delaying this modest rate hike could have hurt economic confidence in the near term, it could also have done much greater damage to confidence in the Fed in the long term.

There is great value, to both the Federal Reserve and the overall financial system, to markets believing that the Fed will ultimately do what it says it will do. It is this credibility that has helped the Fed keep inflation under control over decades, as well as effectively execute its other policy objectives. For a while now, Fed policymakers had implied – or at least, markets had clearly inferred – that a first rate hike would probably come by the end of this year. Limiting surprises to markets helps preserve the credibility the Fed has painstakingly built up over the years, a goal that Fed Chair Janet Yellen has stressed before.

The value of enhancing the Fed’s reputation likely exceeded any negative, and perhaps negligible, consequences of raising rates by a mere 25 basis points.